Going virtual?

By Mphaso Banda, Executive Chairman, Hiraeth Financial

There is a lot of scepticism surrounding virtual currencies especially after considering the eye-popping valuations of virtual currencies like Bitcoin. Complex explanations of how they work and confusing technical jargon had seen virtual currencies take a back seat in the minds of investors; however, the recent surge in popularity of virtual currencies has propelled them into the spotlight once again.

The concept

Virtual currencies come in two flavours, centralised virtual currencies and decentralised virtual currencies (DCVCs). The latter being of concern as centralised virtual currencies are usually confined to a particular community while decentralised currencies interact extensively with the real economy. The idea behind DCVCs is that they will provide a means for people to transact with each other without “costly” middlemen (in the form of commercial banks) and free of manipulation by governments or regulatory bodies. Instead of a bank verifying transactions, they will instead be verified via peer to peer networking. The idea is romantic, although it is unlikely that we will see virtual currencies replace traditional currencies any time soon.

There is no central authority responsible for virtual currency transactions so counterparty risk and issues of settlement rest with the individuals involved in each transaction. Virtual currency is held in a sort of digital wallet. Payments are made directly from one individual to another. These transactions are then verified by peers connected to the network through a process commonly referred to as mining.

Virtual currencies are purchased from virtual currency exchanges. These operate much like a traditional exchange and act as a means for buyers and sellers to find the best bids and offers for a virtual currency, the most popular being Bitcoin and a virtual currency called Ethereum. These exchanges also provide wallets which are the means by which virtual currencies are stored. These wallets are similar in concept to a bank account except for the fact that a wallet can be stored on a local machine e.g. Laptop or cell phone.

Virtual currency regulation

The development of a regulatory framework for virtual currencies in South Africa is still in its formative stage. The fragmented regulatory environment of virtual currencies makes it difficult to use virtual currencies as a method of payment across borders. In 2014 the South African Reserve Bank came out with a position paper on virtual currencies explaining its stance on virtual currency regulation. A key issue that was cited in the paper was the possible, and perhaps likely circumvention of exchange control regulation. In terms of the rules, South African residents are afforded a foreign capital allowance of R4 million per calendar year. Due to the anonymity of virtual currency transactions and their unregulated nature it would make exchange control regulations difficult to enforce. Another key concern is the interaction between virtual currencies and the real economy and the possible substitution effect it might have on fiat currencies ultimately impacting on the central banks’ ability to influence short term interest rates.

In the paper, the South African reserve bank states that “it does not oversee, supervise or regulate the VC landscape, systems or intermediaries for effectiveness, soundness, integrity or robustness. Consequently, any and all activities related to the acquisition, trading or use of VCs (particularly DCVCs) are performed at the end-user’s sole and independent risk and have no recourse to the Bank”. Since then there has been no major progress in the way of regulation which ironically has made it more difficult for virtual currencies to take-off.

There is a need for comprehensive regulation as many brokerage houses have been adding virtual currency derivatives to their product lines. Combine that with the anonymity of virtual currency transactions and it is easy to get a feel for the potentially draconian consequences of inadequate regulation. Some of the key issues that were highlighted in the position paper from the Reserve bank were related to the significant level of risk that users of virtual currencies are exposed to:

Transaction processing errors are usually not reversible, incorrect payment details or a technical error with the payment system could result in irrecoverable losses

The volatility and unregulated nature of virtual currencies

The absence of insurance mechanisms to make account holders whole should a virtual currency wallet or exchange operator fail and accounts become inaccessible

Virtual currency exchanges are not obligated to provide disclosures to consumers related to service fees or charges associated with VC transactions.

Tax implications of virtual currency transactions

While there are no explicit guidelines on the tax treatment of virtual currencies in South Africa, it could be useful to use other jurisdictions as a reference as to the direction of virtual currency regulation. Indirect taxes such as VAT are not levied on virtual currencies in South Africa. This is in line with regulation in the EU where virtual currencies are exempt from GST (General Sales Tax). Other countries like Japan and Australia have adopted a similar stance.

In the United States, the IRS (Internal Revenue Service) has classified Bitcoins as property for tax purposes. This means that for every transaction in virtual currencies, the gains or losses realised must be recorded. It almost goes without saying that such an overly cumbersome approach will not gain traction in South Africa. While virtual currency space enjoys lax regulation for the time being, it is safe to assume that more comprehensive regulation will be put in place especially as virtual currencies gain more traction.

Tax leakage is also a concern if virtual currencies are to see wider use due to their inherent anonymity. The reconstruction of the transaction history of virtual currencies is very difficult and the probability of obtaining useful information from attempting to do so is low. Issues of money laundering have been a major drawback in terms of virtual currency acceptance into the main stream economy due to the difficulty in tracking the flow of virtual currencies.

The intention of virtual currencies could be the very thing that limits them. It is unlikely that we will see commercial scale lending in virtual currencies without well-defined regulation. This kind of control and oversight was what virtual currencies aimed to avoid in the first place. There is no immediate threat to traditional currencies or traditional payment systems although it never hurts to be in the know.

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